Many community banks are reluctant to consider interest rate swaps due to perceived complexity as well as accounting and regulatory burdens. But, in a record low interest rate environment, the most desirable customers almost universally demand something that is hard for community banks to deliver: a long-term, fixed interest rate. Large banks are eager to accommodate this demand and usually do so by offering such a borrower an interest rate swap that, together with the loan facility, delivers the borrower a net long-term, fixed rate obligation and the lending bank a loan with an effective variable rate.

The alternatives to using swaps are not appealing. A community bank can limit its product offerings to only variable rate loans or short-term, fixed rate loans and thereby lose many good customers to larger competitors. The bank can offer a long-term fixed rate on the loan and then (a) sell the loan and lose ongoing earnings and the customer relationship, or (b) borrow long-term funds from the Federal Home Loan Bank to match that asset with appropriate liabilities, a choice that significantly erodes profit on the loan and uses up precious wholesale liquidity.

If a community bank wants to compete using interest rate swaps, then there are three general methods for packaging an interest rate swap with a typical loan offered by a community bank. There are several regulations that apply to swaps, including changes to the Commodities Exchange Act enacted by the Dodd-Frank Act and the numerous related rules and regulations promulgated by the U.S. Commodity Futures Trading Commission (the “CFTC”). If the community bank is under $10 billion in assets, then all three swap methods described below should qualify for an exemption from regulatory requirements that interest rate swaps be cleared through a derivatives exchange. Avoiding clearing requirements saves considerable costs and operational effort.

The first is a one-way swap in which a community bank simply makes a long term, fixed-rate loan to its borrower and then executes an interest rate swap with a swap dealer (such as a broker-dealer affiliate of a larger commercial bank) to hedge against rising interest rates. In a one-way swap, the community bank is subject to fair value hedge accounting, which requires the bank to mark the swap to market on its balance sheet and run changes in fair value through its income statement.

The second is a two-way swap, otherwise known as a back-to-back swap, in which the community bank makes a variable rate loan to its borrower and enters into an interest rate swap with the borrower that, together with the loan facility, delivers the borrower an effective fixed-rate obligation and the lending bank a loan with an effective variable rate. The bank then enters into an offsetting swap with a swap dealer. Even though the terms of the two swaps in a two-way swap may be identical economically, the two swaps can present quite different credit risks to the community bank and the bank may still have to, under accounting rules, track a significant variance between the two swaps.

Both one-way and two-way swaps have some other disadvantages. Under the CFTC’s proposed margin (collateral) regulations , financial end-users of swaps such as community banks likely will have to post initial and variation collateral to secure obligations under swaps. In one-way and two-way swaps, the borrower and the community bank must maintain records that are complete, systematic, retrievable and include, among other things, all records demonstrating the bank qualified for an exception from swap clearing requirements. Also, in a two-way swap, the community bank must ensure that the swap is economically appropriate to reduce the borrower’s interest rate risk and fulfill the bank’s reporting obligations to swap clearing organizations.

The third method is an outsourced swap product designed for community banks. Under this model, the community bank makes a variable rate loan and the borrower signs a simplified swap-type agreement with the swap provider, which results in the bank receiving its preferred variable rate and the borrower paying a net fixed rate. This third method generally does not carry the disadvantages of the first two methods if the provider has properly designed the product.

Once your bank has decided which method or methods it wishes to use with interest rate swaps, the bank must supplement its policies and procedures (at least its interest rate risk, asset/liability and accounting policies) and train its board, management and applicable staff in several key areas. All of this requires careful study and execution, but it can be done.

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